New Risks and Potential Rewards in Roth IRAs

The Tax Cuts and Jobs Act of 2017 (TCJA) contains both positive and negative news for Roth IRAs. Some of the implications are obvious, but other effects are less apparent.

No Looking Back

The most direct change to Roth IRAs is the elimination of recharacterization opportunities after a conversion. Under prior law, a Roth IRA conversion could be reversed, in part or in full, until October 15 of the following year.

This possibility might have, for example, encouraged John Smith to convert $100,000 of his traditional IRA to a Roth in December 2016. In October 2017, with final numbers on his 2016 return available, John might have recharacterized the precise amount back to his traditional IRA, keeping enough in the Roth IRA to fill out a tax bracket but avoid having any dollars taxed at a higher rate.

More sophisticated strategies abounded. For example, John might have converted that $100,000 into two Roth IRAs, one holding $50,000 of Apple stock and the other holding $50,000 of General Motors stock. If the GM shares had plunged by the following October, John could have recharacterized that IRA in full, reducing his tax bill from the conversion in half. If the Apple shares had appreciated, that Roth IRA could have remained in place, possibly en route to tax-free withdrawals of investment gains, once the age 59½ and five-year holding period hurdles were cleared.

Such lookback strategies no longer exist under the TCJA. Today, a Roth IRA conversion will generate taxable income in the year of that transaction, no matter what happens afterwards.

Patience Is Prudent

With no chance at recharacterization, it is vital to convert with care. Consequently, late in the year might be the best time to do a partial conversion. Once annual income can be estimated with some accuracy, the amount to convert can be decided.

Consider, for example, Ann Jones, who has a $500,000 traditional IRA and plans to retire in 10 years. Suppose Ann believes that she can convert $50,000 per year and remain in the 24% bracket; Ann also believes that she can afford to pay the resulting $12,000 (24% of $50,000) in extra tax each year.

Accordingly, Ann plans a series of $50,000 annual conversions. (She assumes the 24% tax rate will remain in effect, regardless of the sunset provisions in the TCJA.) By the time she retires, Ann will have little or no money in her traditional IRA, thereby minimizing required minimum distributions. Her retirement fund will be a Roth IRA, from which she can withdraw untaxed funds regardless of future tax rates.

Besides the ability to fine-tune conversion amounts, year-end Roth IRA conversions offer another benefit: they are always dated on the prior January 1 for purposes of the five-year rule. A conversion in late December 2019, for instance, will reach the five-year mark on January 1, 2024.

Lower Rates, Higher Ceilings

As explained, the TCJA’s removal of recharacterization strategies may discourage some taxpayers from executing Roth IRA conversions. As an offset, the law also lowered tax rates: instead of the rates from 10% to 39.6% that faced taxpayers in 2017, current rates go from 10% to 37%. What’s more, some joint return tax brackets have expanded to twice the size of the single filers’ bracket, which was not always true in the past. The bottom line is that many taxpayers will be in the 12%, 22%, and 24% tax brackets, making Roth IRA conversions less taxing than in the past.

Indeed, many taxpayers have deferred tax via retirement accounts, avoiding current tax bills that would have been due at rates as high as 39.6%. Converting those dollars to potentially tax-free Roth IRAs at lower rates may be appealing.

Moreover, lower tax rates make traditional 401(k) and other tax-deferred retirement plans less advantageous. Deferring tax that would have been owed at 12%, 22%, or 24% might be unattractive if there is a chance future withdrawals will be taxed at higher rates. Indeed, the TCJA calls for the higher tax rates of 2017 to be restored in 2026.

Therefore, some taxpayers may prefer to pay tax now, at 2019 rates, and put their money into after-tax retirement accounts such as Roth IRAs and Roth versions of employer-sponsored retirement accounts. In effect, they would not be deferring tax in a 401(k), rolling that money to a traditional IRA, and then converting to a Roth IRA, which has been customary. Instead, they would be going straight to the after-tax plans, where future distributions may be tax-free. (Taxpayers with income too high for Roth IRA contributions might be able to accomplish the same thing through the “back door,” via a nondeductible contribution to a traditional IRA and a subsequent Roth IRA conversion, if they have no pretax money in traditional IRAs.)

Some taxpayers may prefer to pay tax now, at 2019 rates, and put their money into after-tax retirement accounts such as Roth IRAs.

How IRC Section 199A Affects Roth Accounts

The TCJA adds section 199A to the Internal Revenue Code (IRC), creating a qualified business income (QBI) deduction for certain pass through entities. How do Roth IRAs interact with section 199A and QBI? There is a quirk in the QBI rules: the QBI deduction is capped at the lesser of 20% of QBI or 20% of taxable income. If, for example, Mary’s taxable income is $70,000, she can take a $14,000 (20% of $70,000) QBI deduction, not $20,000. In this scenario, Mary might convert just over $30,000 of her traditional IRA to a Roth IRA, adding this amount to her taxable income would make Mary’s $100,000 of QBI the lesser number, allowing her to take the maximum $20,000 QBI tax deduction.

Mary would owe tax on the Roth IRA conversion, but that tax increase would be partially offset by the larger QBI deduction. Assuming the conversion amount is calculated to bring taxable income just over QBI, the effective marginal rate would be approximately 80% of the federal rate. Thus, a taxpayer in the 24% bracket might effectively move money into a Roth IRA at a tax rate of approximately 19.2% (80% of 24%).

In some cases, similar math could apply to retirement plan contributions. Assume, for example, that Carl Davis owns 100% of an S corporation. If Carl’s company sponsors a pretax retirement account such as a traditional 401(k), and he is in the 22% tax bracket, contributing to the 401(k) would reduce the S corporation’s QBI. That could reduce the QBI deduction, so Carl might be deferring income tax at 17.6%—80% of 22%—with a contribution to the traditional 401(k).

Checklist for Roth IRA Conversions

[ ] Plan carefully, as there is no opportunity for recharacterization after a reversal.

[ ] Late in the year may be an ideal time for partial Roth IRA conversions. Annual income may be known then, the better to aid in calculating the amount for a low-tax conversion. A conversion late in the year will be treated as being executed the previous January 1 for purposes of the five-year requirement for tax-free Roth IRA withdrawals.

[ ] The relatively low tax rates under the TCJA may make a Roth IRA conversion less onerous.

[ ] When saving for retirement, some may prefer to pay the tax now, at TCJA rates, and contribute to after-tax Roth accounts.

[ ] Business owners may find the new qualified business income rules favor after-tax Roth account contributions and the opportunity for untaxed distributions in the future, rather than the tax deferral offered by traditional retirement plans.

[ ] Married couples might want to convert some traditional IRA dollars to Roth IRAs in order to reduce future taxable required minimum distributions and provide a source of untaxed cash flow for the widow or widower.

Taxpayers in such situations might not want to defer tax at 17.6% if the money could be taxed at a higher rate in the future on distributions. Here, Carl might want to offer a Roth 401(k) as part of the company’s plan and contribute after-tax dollars that might eventually generate untaxed distributions. Carl and his wife may decide to use Roth IRA contributions to fund their retirement rather than defer low-taxed dollars.

Welcomed by Widows and Widowers

As mentioned previously, one main feature of the TCJA is the widening of tax brackets. This means that married couples with incomes well into six figures face relatively lower marginal rates, with brackets indexed for inflation, now scheduled to remain in effect through 2025.

For most married couples, however, the death of a spouse will move the survivor to the single filers’ tables, starting in the year after death. Often, the widow or widower’s taxable income will not be much lower that the couple’s income had been. The smaller Social Security benefit will disappear, but the standard tax deduction will be cut sharply as well. Investment income will probably be the same, as will any income from rental property, and pensions may have a survivor’s benefit.

Roth IRA conversions must be crafted more carefully now that they cannot be reversed.

As a result, a widow or widower may have similar income but fall into a higher bracket. For some widows or widowers, similar income may have to support higher Medicare premiums per participant or a higher tax rate on Social Security benefits.

Planning can help with this potential problem. One aspect of such a plan may be a series of Roth IRA conversions, before and after retirement, while both spouses are alive. Careful calculations can keep each year’s conversion in a relatively low joint tax bracket under the TCJA rates. Over a period of years, most or all of a traditional IRA can be moved to the Roth side. That can reduce taxable required minimum distributions and provide an ample source of tax-free Roth IRA distributions, which will not swell reported taxable income.

Altogether, the impact of the TCJA can be felt in many financial decisions. Roth IRA conversions must be crafted more carefully now that they cannot be reversed, but utilizing Roth IRAs and other Roth accounts can help reduce tax bills in the long term.

Sidney Kess, JD, LLM, CPA is of counsel to Kostelanetz & Fink and a senior consultant to Citrin Cooperman & Co., LLP. He is a member of the NYSSCPA Hall of Fame and was awarded the Society’s Outstanding CPA in Education Award in May 2015. He is also a member of The CPA Journal Editorial Advisory Board.

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